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Can fiscal stimulus end a recession?

© 2013 Pearson 16 When you have completed your study of this chapter, you will be able to 1 Describe the federal budget process and the recent history of tax revenues, outlays, deficits, and debts. 2 Explain how fiscal stimulus is used to fight a recession. 3 Explain the supply-side effects of fiscal policy on employment, potential GDP, and the economic growth rate. CHAPTER CHECKLIST Fiscal Policy

© 2013 Pearson 16.1 THE FEDERAL BUDGET The federal budget is an annual statement of the revenues, outlays, and surplus or deficit of the government of the United States. The federal budget has two purposes: 1. To finance the activities of the federal government 2. To achieve macroeconomic objectives Fiscal policy is the use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment.

© 2013 Pearson 16.1 THE FEDERAL BUDGET  The Institutions and Laws The President and the Congress make the budget and develop fiscal policy on a fixed annual time line. Fiscal year is a year that begins on October 1 and ends on September 30 of the next year.

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16.1 THE FEDERAL BUDGET  Budget Surplus, Deficit, and Debt Budget balance = Tax revenues – Outlays The government has a balanced budget when tax revenues equal outlays (budget balance is zero). The government has a budget surplus when tax revenues exceed outlays (budget balance is positive). The government has a budget deficit when outlays exceed tax revenues (budget balance is negative).

© 2013 Pearson 16.1 THE FEDERAL BUDGET The government borrows to finance a budget deficit and repays its debt when it has a budget surplus. The amount of debt outstanding that arises from past budget deficits is called national debt. Debt at end of 2012 = Debt at end of Budget deficit in 2012.

© 2013 Pearson 16.1 THE FEDERAL BUDGET  The Federal Budget in Fiscal 2012 © 2013 Pearson

16.1 THE FEDERAL BUDGET On the tax revenues side of the budget: The largest item is personal income taxes―taxes that people pay on wages and salaries and on interest. The second largest item is Social Security taxes―taxes paid by workers and employers to fund Social Security benefits. Corporate income taxes, which are the taxes paid by corporations on their profits, are much smaller. Indirect taxes, the smallest revenue source, are sales taxes and customs and excise taxes.

© 2013 Pearson 16.1 THE FEDERAL BUDGET On the outlays side of the budget: The largest item is transfer payments. Transfer payments are Social Security benefits, Medicare and Medicaid benefits, unemployment benefits, and other cash benefits paid to individuals and firms. Expenditure on goods and services includes the government’s defense and homeland security budgets. Debt interest is the interest on the national debt.

© 2013 Pearson 16.1 THE FEDERAL BUDGET  A Social Security and Medicare Time Bomb There are 77 million “baby boomers” in the United States and the first of them started to collect Social Security pensions in 2008 and became eligible for Medicare in By 2030, all baby boomers will be supported by Social Security and Medicare and benefit payments will have doubled. The government’s Social Security obligations are a debt. How big is this debt?

© 2013 Pearson 16.1 THE FEDERAL BUDGET Jagadeesh Gokhale and Kent Smetters estimate that this debt was $80 trillion in 2011 and it grows by $3 trillion a year. In 2010, U.S. GDP was $14.5 trillion, so this debt is equivalent to 5.5 years of GDP. This time bomb is huge and points to a catastrophic future. How can the government meet these obligations?

© 2013 Pearson 16.1 THE FEDERAL BUDGET The government has four alternatives: Raise income taxes Raise Social Security taxes Cut Social Security benefits Cut other federal government spending To defuse the time bomb, income taxes would need to be raised by 69 percent or Social Security raised by 95 percent or Social Security benefits cut by 56 percent.

© 2013 Pearson  Schools of Thought and Cracks in Today’s Consensus The three main schools of macroeconomic thought are classical, Keynesian, and monetarist macroeconomics. Today’s consensus is one that takes insights from each of the schools. While there is a consensus, the macroeconomic events of 2008 and 2009 have placed the consensus under some stress and cracks are emerging. The main crack is between the views of Keynesian economists and others FISCAL STIMULUS

© 2013 Pearson The Keynesian View The Keynesian view is that fiscal stimulus —an increase in government outlays or a decrease in tax revenues— boosts real GDP and creates or saves jobs. Fiscal stimulus boosts real GDP and employment by increasing aggregate demand and the fiscal stimulus has a multiplier effect. Keynesians say that these positive effects of fiscal stimulus make it a vital and powerful tool in the fight against deep recession and depression FISCAL STIMULUS

© 2013 Pearson The Mainstream View The mainstream view is that Keynesians overestimate the multiplier effects of fiscal stimulus and their effects are small, short-lived, and incapable of working fast enough to be useful. Mainstream economists say that government stimulus “crowds out” investment. The durable results of a fiscal stimulus are bigger government, lower potential GDP, a slower real GDP growth rate, and a greater burden of government debt on future generations FISCAL STIMULUS

© 2013 Pearson 16.2 FISCAL STIMULUS  Fiscal Policy and Aggregate Demand Fiscal policy is a change in government outlays or in tax revenues. Other things remaining the same, a change in any item in the government budget changes aggregate demand. These changes might occur as an automatic response to the state of the economy or as a result of new spending or tax decisions by Congress.

© 2013 Pearson 16.2 FISCAL STIMULUS Automatic Fiscal Policy Automatic fiscal policy is a fiscal policy action that is triggered by the state of the economy. For example, an increase in unemployment induces an increase in payments to the unemployed or in a recession tax receipts decrease as incomes fall.

© 2013 Pearson 16.2 FISCAL STIMULUS Discretionary Fiscal Policy Discretionary fiscal policy is a fiscal policy action that is initiated by an act of Congress. For example, an increase in defense spending or a cut in the income tax rate.

© 2013 Pearson 16.2 FISCAL STIMULUS  Automatic Fiscal Policy A consequence of tax revenues and outlays that fluctuate with real GDP. Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government. Induced Taxes Induced taxes are taxes that vary with real GDP.

© 2013 Pearson 16.2 FISCAL STIMULUS Needs-Tested Spending Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits—benefits that vary with need and with the state of the economy. Induced taxes and needs-tested spending decrease the multiplier effects of change in autonomous expenditure and moderate both expansions and recessions and make real GDP more stable.

© 2013 Pearson 16.2 FISCAL STIMULUS Automatic Stimulus Because government tax revenues fall and outlays increase in a recession, the budget provides automatic stimulus that helps to shrink the recessionary gap. Similarly, because tax revenues rise and outlays decrease in a boom, the budget provides automatic restraint to shrink an inflationary gap. Fluctuations in the government budget balance over the business cycle create a need to distinguish between the budget’s cyclical balance and structural balance.

© 2013 Pearson 16.2 FISCAL STIMULUS  Cyclical and Structural Budget Balances A structural surplus or deficit is the budget balance that would occur if the economy were at full employment. A cyclical surplus or deficit is the budget balance that arises because tax revenues and outlays are not at their full-employment levels. The actual budget balance is the sum of the structural balance and the cyclical balance.

© 2013 Pearson 16.2 FISCAL STIMULUS  Discretionary Fiscal Policy Discretionary fiscal policy can take the form of a change in government outlays or a change in tax revenues. Other things remaining the same, a change in any of the items in the government budget changes aggregate demand and … has a multiplier effect—aggregate demand changes by a greater amount than the initial change in the item in the government budget.

© 2013 Pearson 16.2 FISCAL STIMULUS The Government Expenditure Multiplier The government expenditure multiplier is the effect of a change in government expenditure on goods and services on aggregate demand. An increase in aggregate expenditure increases aggregate demand, which increases real GDP. The increase in real GDP induces an increase in consumption expenditure, which further increases aggregate demand.

© 2013 Pearson 16.2 FISCAL STIMULUS The Tax Multiplier The tax multiplier is the effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income. The increase in disposable income increases consumption expenditure and aggregate demand. With increased aggregate demand, employment and real GDP increase and consumption expenditure increases yet further.

© 2013 Pearson 16.2 FISCAL STIMULUS So a decrease in taxes works like an increase in government expenditure. Both actions increase aggregate demand and have a multiplier effect. The magnitude of the tax multiplier is smaller than the government expenditure multiplier. The reason: A $1 tax cut increases aggregate expenditure by less than $1 whereas a $1 increase in government expenditure increases aggregate expenditure by $1.

© 2013 Pearson 16.2 FISCAL STIMULUS The Transfer Payments Multiplier The transfer payments multiplier is the effect of a change in transfer payments on aggregate demand. This multiplier works like the tax multiplier but in the opposite direction. An increase in transfer payments increases disposable income, which increases consumption expenditure. With increased consumption expenditure, employment and real GDP increase and consumption expenditure increases yet further.

© 2013 Pearson 16.2 FISCAL STIMULUS The Balanced Budget Multiplier The balanced budget multiplier is the effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged. The balanced budget multiplier is not zero—it is positive—because the government expenditure multiplier is larger than the tax multiplier.

© 2013 Pearson 16.2 FISCAL STIMULUS  A Successful Fiscal Stimulus If real GDP is below potential GDP, the government might pursue a fiscal stimulus by: Increasing government expenditure on goods and services, Increasing transfer payments, Cutting taxes, or A combination of all three. Cash for Clunkers was a fiscal stimulus.

© 2013 Pearson 16.2 FISCAL STIMULUS Potential GDP is $13 trillion, real GDP is $12 trillion, and 1. There is a $1 trillion recessionary gap. 2. An increase in government expenditure or a tax cut increases expenditure by ∆E. Figure 16.2 illustrates a fiscal stimulus.

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16.2 FISCAL STIMULUS 3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD 1. The price level rises to 110, real GDP increases to $13 trillion, and the recessionary gap is eliminated.

© 2013 Pearson 16.2 FISCAL STIMULUS  Limitations of Discretionary Fiscal Policy The use of discretionary fiscal policy is seriously hampered by four factors: Law-making time lag Shrinking area of law-maker discretion Estimating potential GDP Economic forecasting

© 2013 Pearson 16.2 FISCAL STIMULUS Law-Making Time Lag The amount of time it takes Congress to pass the laws needed to change taxes or spending. This process takes time because each member of Congress has a different idea about what is the best tax or spending program to change, so long debates and committee meetings are needed to reconcile conflicting views.

© 2013 Pearson 16.2 FISCAL STIMULUS Shrinking Area of Law-Maker Discretion Expenditure on the military and on homeland security and very large expansion in expenditure on entitlement programs such as Medicare has increased. The result is that around 80 percent of the federal budget is effectively off limits for discretionary fiscal policy action. The 20 percent that is available for discretionary change include items such as education and the space program, which are hard to cut.

© 2013 Pearson 16.2 FISCAL STIMULUS Estimating Potential GDP It is not easy to tell whether real GDP is below, above, or at potential GDP. So a discretionary fiscal action might move real GDP away from potential GDP instead of toward it. This problem is a serious one because too much fiscal stimulation brings inflation and too little might bring recession.

© 2013 Pearson 16.2 FISCAL STIMULUS Economic Forecasting Fiscal policy changes take a long time to enact in Congress and yet more time to become effective. So fiscal policy must target forecasts of where the economy will be in the future. Economic forecasting has improved enormously in recent years, but it remains inexact and subject to error. So for a second reason, discretionary fiscal action might move real GDP away from potential GDP and create the very problems it seeks to correct.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Fiscal policy influences the output gap by changing aggregate demand and real GDP relative to potential GDP. But fiscal policy also influences potential GDP and the growth rate of potential GDP. These influences on potential GDP and economic growth arise because The government provides public goods and services that increase productivity and Taxes change the incentives the people face.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Supply-side effects are the effects of fiscal policy on potential GDP. Supply-side effects operate more slowly than the demand-side effects. Supply-side effects are often ignored in times of recession when the focus is on fiscal stimulus and restoring full employment. But in the long run, the supply-side effects of fiscal policy dominate and determine potential GDP.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH  Full Employment and Potential GDP The higher the real wage rate, other things remaining the same, the smaller is the quantity of labor demanded and the greater is the quantity of labor supplied. When the real wage rate has adjusted to make the quantity of labor demanded equal to the quantity of labor supplied, there is full employment. When the quantity of labor is the full-employment quantity, real GDP equals potential GDP.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH  Fiscal Policy, Employment, and Potential GDP Both sides of the government's budget influences potential GDP. Public Goods and Productivity The expenditure side provides public goods and services that enhance productivity. The increase in productivity increases potential GDP.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Taxes and Incentives On the revenue side, taxes modify incentives and change the full-employment quantity of labor, as well as the amount of saving and investment. An increase in taxes drives a wedge between the price paid by the buyer and the price received by a seller. In the labor market, tax wedge is the gap between the before-tax wage rate and the after-tax wage rate. The result is a decrease in the full-employment quantity of labor and a decrease in potential GDP.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Full Employment with No Income Tax The wage rate is $30 an hour and 250 billion hours of labor is employed.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH The economy is at full employment with 250 billion hours of labor employed. The production function shows that when 250 billion hours are employed, potential GDP is $14 trillion.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH The Effects of the Income Tax The income tax 1.Decreases the supply of labor. 2. Creates a tax wedge between the wage rate that firms pay and workers receive.

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3.The before-tax wage rate rises to $35 an hour. 4.The after-tax wage rate falls to $20 an hour. 5.Full employment decreases to 200 billion hours THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH 5. Full employment decreases to 200 billion hours. 6. Potential GDP decreases to $13 trillion.

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16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Changes in the Tax Rate A change in the income tax rate changes equilibrium employment and potential GDP. In the example that you’ve just worked through, the tax rate is about 43 percent—a $15 tax on a $35 wage rate. If the income tax rate is increased, the supply of labor decreases yet more and the LS + tax curve shifts farther leftward. Equilibrium employment and potential GDP decrease.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH  Taxes, Deficits, and Economic Growth Fiscal policy influences economic growth in two ways: 1.Taxes drive a wedge between the interest rate paid by borrowers and the interest rate received by lenders. 2.If there is a budget deficit, government borrowing to finance the deficit competes with firms’ borrowing to finance investment and to some degree, government borrowing “crowds out” private investment.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Interest Rate Tax Wedge Lenders pay an income tax on the interest they receive from borrowers, which creates an interest rate tax wedge. A tax on interest lowers the quantity of saving and investment and slows the growth rate of real GDP. A tax on interest income creates a Lucas wedge—an ever widening gap between potential GDP and the potential GDP that might have been.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Investment and saving plans depend on the real after- tax interest rate. The real interest rate equals the nominal interest rate minus the inflation rate. So the after-tax interest rate equals the real interest rate minus the income tax paid on interest income. But the nominal interest rate, not the real interest rate, determines the amount of tax to be paid; and the higher the inflation rate, the higher is the nominal interest rate, and the higher is the true tax rate on interest income.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH Deficits and Crowding Out A tax cut that increases the budget deficit brings an increase in the demand of loanable funds to firms. The interest rate rises and crowds out private investment. But the lower income tax rate shrinks the tax wedge and stimulates employment, saving, and investment. But a higher budget deficit decreases investment.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH  Combined Demand-Side and Supply-Side Effects A fiscal stimulus increases aggregate demand and potential GDP. When potential GDP increases aggregate supply increases. Equilibrium real GDP increases, but the price level might rise, fall, or not change. Figure 16.4 shows the combined effects of fiscal policy when fiscal policy has no effect on the price level.

© 2013 Pearson 16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH 1. A tax cut increases disposable income, which increases aggregate demand from AD 0 to AD 1. A tax cut also strengthens the incentive to work, save, and invest, which increases aggregate supply from AS 0 to AS Real GDP increases.

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16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH  Long-Run Fiscal Policy Effects The long-run consequences are the most profound ones. If investment is crowded out by a large budget deficit, the economic growth rate slows and potential GDP gets ever farther below what it might have been as the Lucas wedge widens. If a large budget deficit persists, debt increases, confidence in the value of money is eroded, and inflation erupts. It is vital that government outlays and budget deficits be kept under control.

© 2013 Pearson Did Fiscal Stimulus End the Recession? In February 2009, in the depths of the 2008–2009 recession, Congress passed the American Recovery and Reinvestment Act, a $787 billion fiscal stimulus package. This Act of Congress is an example of discretionary fiscal policy. Did this action by Congress contribute to ending the 2008– 2009 recession and making the recession less severe than it might have been? The Obama Administration economists are confident that the stimulus package made a significant contribution to easing and ending the recession.

© 2013 Pearson But many, and perhaps most, economists don’t agree. They think that the stimulus package played a small role and that the truly big story is not discretionary fiscal policy but the role played by automatic stabilizers. What were the fiscal policy actions and their likely effects? Discretionary Fiscal Policy President Obama promised that fiscal stimulus would save or create 650,000 jobs by the end of the 2009 summer. In October 2009, the Administration economists declared that the fiscal stimulus had saved or created the promised 650,000 jobs. Did Fiscal Stimulus End the Recession?

© 2013 Pearson This claim of success might be correct, but it isn’t startling and it isn’t a huge claim. Why? How much GDP would 650,000 people produce? In 2009, each employed person produced $100,000 of real GDP on average. So 650,000 people would produce $65 billion of GDP. But only 20 percent of the $787 billion stimulus package had been spent (or taken in tax breaks), so the stimulus was only about $160 billion. If government outlays of $160 billion created $65 billion of GDP, the multiplier was 0.4 (65/160 = 0.4). Did Fiscal Stimulus End the Recession?

© 2013 Pearson This multiplier is much smaller than the 1.6 that the Obama economists say will eventually occur. They believe, like Keynes, that the multiplier starts out small and gets larger over time as spending plans respond to rising incomes. An initial increase in expenditure increases aggregate expenditure. But the increase in aggregate expenditure generates higher incomes, which in turn induces greater consumption expenditure. Did Fiscal Stimulus End the Recession?

© 2013 Pearson Automatic Fiscal Policy Government revenue is sensitive to the state of the economy. When personal incomes and corporate profits fall, income tax revenues fall too. When unemployment increases, outlays on unemployment benefits and other social welfare benefits increase. These fiscal policy changes are automatic. They occur with speed and without help from Congress. Did Fiscal Stimulus End the Recession?

© 2013 Pearson In 2009, real GDP fell to 6 percent below potential GDP—a recessionary gap of $800 billion. Tax revenues crashed and transfer payments skyrocketed. The figure shows that the automatic stabilizers were much larger than the discretionary actions. Automatic action played the major role in limiting job losses. Did Fiscal Stimulus End the Recession?